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Clifford Neely October Consultants, Inc. PO Box 59208 Potomac, MD 20859 301 738 3321 Career 1988 to present: Principal, October Consultants, Inc. October Consultants conducts economic analysis and market research for clients in the floor coverings and chemical industries. 1976 to 1988:... More
  • The First Taper Plunge 0 comments
    Jun 28, 2013 9:37 AM

    Chairman Bernanke's mention that the Federal Reserve Board might slow its $85 billion per month rate of Government asset purchases had dire consequences.

    Markets around the world reacted violently. The FRB had to issue reassurances that the money bar was still open. Ironically, the first hint of an end to monetary easing may have actually resulted in central banks across the globe making money more available.

    This much we know about the situation in the U.S. one week after the plunge. Markets have stabilized, the Dow Jones Industrial average is back above 15,000, the dollar is strong, gold prices have plummeted to the $1,225/oz level, and the yield on the 10-year bond is back to 2.5%.

    The lesson of the June plunge is that low interest rates are essential. Any effort to bring interest rates higher, no matter how gentle or nuanced, is going to be painful and destabilizing. Financial markets simply do not believe that the economy is strong enough to handle higher interest rates. They know the debt structure isn't.

    Mentioning the possibility of reducing asset purchases at the last FRB meeting was probably a mistake. Mr. Bernanke surely recognizes that the economy is far too weak to stand on its own right now and that abnormally low interest rates have to continue for yet a number of years. This suggests that it may not have been so much a voluntary statement as a diktat forced on him by finance ministers from countries worried about the value of their dollar reserves. The rest of the world may be losing its ardor for dollars and may have threatened to stop buying our paper.

    Hints that external forces may have pushed Mr. Bernanke into a more hard-line position than he would have liked can be gleaned from President Obama's comment on PBS that Bernanke had stayed, "…a lot longer than he wanted to or he was supposed to." Former FRB chairman Greenspan also commented earlier that Bernanke might not have so long to hold interest rates down as he thinks he does.

    There is nothing new about foreign central banks putting pressure on the U.S. to change its monetary policy. What is different in this episode is that there are far more chips on the table than ever before and the outcome of any actions taken will be far more consequential. In 1979, German central bankers suggested to President Carter that he appoint a hard-liner, "someone like Paul Volker", to be Chairman of the FRB in order to bring double-digit inflation under control. President Carter chose Mr. Volker and by 1982 the rate of inflation had fallen to under 4%.

    Today, two fundamental flaws (the inability to create jobs and the need for very low interest rates) have deformed the economy far more than was the case in Mr. Volker's time. Mr. Volker had the luxury of being able to slow growth in the money supply, increase interest rates, and drain liquidity from the system over a number of years.

    Mr. Bernanke is bumping into limits on how much more he can do, as real interest rates are already negative. The economy is still as dependent on outsized monetary and fiscal stimulus as it was when Mr. Obama took office. It is still dependent on borrowing about $500 billion a year overseas to cover chronic negative trade balances. The monetary spigots have to stay wide open or the economy will slip back into depression. Take the stimulus away tomorrow, and the economy will sputter and quit. There is no option but to keep the economy moving forward. Interest rates have to stay abnormally low, probably no higher than 2.5% on the10-year bond.

    The contretemps right now is that the needs and desires of the U.S. are likely clashing with the needs and desires of our creditors. Friendly discussions could turn confrontational, if they are not already.

    Who blinks first? Our guess is that the U.S. will decide that keeping the economy afloat is its top priority and will act unilaterally, if necessary, to keep interest rates low.

    It now appears that the first taper plunge did not end the party. But more plunges can be expected so long as our answer to the threat posed by leveraged debt is to make it possible to leverage even more debt.

    Themes: leverage, Bernanke
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